Cyprus highlights weakness of banking union

Hey there, time traveller!This article was published 25/4/2013 (1323 days ago), so information in it may no longer be current.

THE 1931 collapse of the small Austrian bank Creditanstalt precipitated a major financial panic. Cyprus, one the smallest countries in Europe, may prove a key inflexion point in the crisis.

The EU bailout package included the controversial provision that all ordinary depositors pay a "tax" or "solidarity levy" on Cypriot bank deposits, amounting to a permanent write-down in the nominal value of their deposits.

Initially, the parliament in Cyprus failed to pass the necessary enabling legislation.

Finally, with no other source of funding available, the European Central Bank (ECB) threatening withdrawal of emergency funding and the threat of default and rapid economic collapse, Cyprus agreed to an amended plan where "small" depositors (below €100,000) will be protected, being exempted from the levy.

But a major restructuring of the two largest banks will take place with probable large losses to the unprotected depositors. Other measures include "temporary, proportionate and non-discriminatory" capital controls to prevent funds being taken out of Cyprus.

The measures stave off the risk of immediate collapse and Cyprus having to leave the euro. But the plan does not address Cyprus’ problem.

The proposed restructuring effectively cripples the Cypriot banking industry, which is a major part of the economy and employs more than 50 per cent of the country’s workers. The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations.

Economic activity in Cyprus is expected to contract by 15 to 25 per cent over the next few years. Unemployment will also rise. The slowdown will reduce Cyprus’ capacity to pay back its creditors.

Irrespective of the fate of Cyprus, the solution adopted will exacerbate the European debt crisis.

First, the transfer of losses to depositors creates a dangerous precedent. Depositors in weak banks in weak countries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain.

If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have to intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.

Second, the Cyprus bail-in provision will make it increasingly difficult for European banks, especially in vulnerable countries, to raise new deposits or issue bonds.

Third, the Cyprus arrangements undermine the credibility of the ECB and EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability.

After Cyprus, it will be politically difficult for countries such as Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary, then domestic taxpayers face a loss on their bank deposits.

Cyprus highlights the shortcomings of the EU’s much vaunted "banking union." The arrangements did not provide sufficient funds to undertake any required recapitalization of banks, an alternative to the levy on deposits. Cyprus also highlights the lack of a eurozone-wide consistent deposit-protection scheme, backed by EU funds.

Fourth, the Cyprus package highlights the increasing reluctance of countries such as Germany, Finland and the Netherlands as well as the IMF to support weaker eurozone members. Domestic political considerations and popular resistance to commitments of further taxpayer funds to such bailouts make such assistance increasingly problematic.

Fifth, the negotiations surrounding the Cyprus bailout revealed the policymaker’s lack of understanding of the problems and the effects of policies. It also revealed significant differences between eurozone members and also between Europe and the IMF.

Sixth, the EU, by agreeing to potentially indefinite capital controls, has effectively created a two-tier euro, undermining the single currency in the long term.

Unfortunately, in each attempt at resolution to the European debt crisis, as shown by the proposed Cyprus package, the measures have become the problem rather than a solution.

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.

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